On February 19, 1999, competition will officially come to Europe's electricity markets. European Union directives stipulate that large industrial consumers will then have the right to choose their electricity suppliers—a decision that effectively opens up a quarter of the EU electricity market. At the same time, new players will be allowed to submit tenders for building power stations and supplying customers with power directly over incumbents' transmission networks.¹

A range of regulatory and technological factors will make liberalization proceed at different rates in different places.² Nonetheless, the bottom line is that Europe's utilities face increasing competition. Continental utilities, which will find their markets radically transformed, must decide how to respond. Their counterparts in the United Kingdom and Scandinavia, which are already accustomed to competition, must seek out new opportunities.

For Continental Europeans, the most important fact is simply that the old, vertically integrated model of electricity production has been undermined in the long term. Complex reasons having to do with historic regulations, attitudes about national identity, and the risk of market failure made each country develop large national or regional utilities that owned every part of the process of producing and distributing electricity. Political and technological changes have made this kind of centralization obsolete, so the trade-offs that formerly justified less than optimally efficient integrated systems no longer hold.

In other words, the value chain will break up. Established utilities must study their prospects for profit in each part of the chain in a liberalized environment. Here, we examine the forces transforming the industry, clarify the exceptional cases in which vertical integration can be justified for the time being, and analyze opportunities along the value chain in the developing business arena.

The situation is serious indeed: established utilities may well find themselves bested in the generation of electricity, which was historically their chief value driver. Even so, they have certain structural advantages going into the next phase. And because liberalization will not proceed at a uniform pace everywhere, they may have opportunities to influence the short-term regulatory environment to create a window of opportunity that will help them prepare for full competition.

The hat trick of trouble: Liberalization, technology, environmental regulation

The electricity industry comprises three businesses: generation (converting fuel to electricity in bulk), wires (transmitting and distributing power from stations to users), and retailing (buying power in bulk and selling it to users).³

In the first phase of liberalization, the business downstream—that is, wires and retailing — is typically separated from generation. At this point, generators of electricity must compete to sell their output, and such competition becomes feasible. In the second phase, the wires part of the business is separated from retailing and forced to operate as a "common carrier"; that is, any retailer can sell power across these wires.⁴

The EU's directives aim to bring about such a state of affairs, though several countries are already ahead of the game. In the United Kingdom and Scandinavia, where competition is established, electricity prices have already fallen significantly—by more than 20 percent in the United Kingdom⁵ over the decade since privatization and by 10–20 percent in Scandinavia over six years. Spain⁶ and the Netherlands are trying to speed up the pace of reform.

A number of technological developments that are likely to work against the interests of established players have promoted liberalization (Exhibit 1):

• CCGT (combined-cycle gas turbine) generation gives new entrants significant advantages in cost and flexibility over nuclear and coal because construction costs are lower, and the cost of gas is falling.⁷
• Falling minimum levels of efficient scale have undermined the need for large utilities that can invest in and operate huge new generating plants.
• Over the next five to seven years, a number of potential breakthroughs — all with the attractive features of small-scale efficiency and environmental cleanliness — could turn established utilities into so many buggy-whip companies.

• Fuel cells, which release energy in a combustion-free chemical reaction for transport or heat applications, could dramatically reduce the demand for electricity.
• Microcogen—tiny gas-generating units in homes and workplaces—could eliminate the need for national transmission systems and large generating stations.
• If the petroleum companies investigating the development of small-scale liquefied natural-gas facilities succeed, they will be able to supply gas to many potential new electricity generators, without the prohibitive infrastructure investment currently required.

Technological advances have also promoted more stringent environmental rules: the 1997 Kyoto conference committed the EU to reduce its global warming emissions by 8 percent no later than 2008–12. It now appears certain that high-emission plants will be closed or scaled down.

Finally, a more subtle point: quite apart from any technological strengths that new entrants may have, they often bring managerial and service advantages to the business. If new entrants can identify and target attractive customer segments, these competitors will be looking to do to the electricity industry what First Direct and Worldcom did in financial services and telecommunications, respectively — apply IT to move into new segments quickly, untrammeled by past investments and management practices. In this way, such new entrants will displace established players.

The end of vertical integration

Established utilities must begin by recognizing that vertical integration should be milked for its short- and medium-term benefits. But except in rare cases, it is not a long-term option.

Although it may remain legal to own businesses in adjacent sectors of the value chain, legislation will require such business to be operated at arm's length. As a result, the benefits of integration—above all, an opaqueness that allowed utilities to camouflage what they charged for each part of their service—will start to disappear.

Abandoning a vertically integrated mindset after many decades will be difficult and controversial for most established European utilities. They will argue, among other things, that the scale of an integrated company gives them the clout needed to negotiate good terms with regulators, helps them raise financing relatively cheaply in capital markets, and appeals to industrial customers. Ultimately, however, the imperatives of the EU mandate and the example of nonintegrated new entrants that successfully move to steal markets will expose vertical integration as an impediment to focus and survival. Disaggregation is inevitable (Exhibit 2).

Vertical integration poses its own risks, anyway. Transfer pricing, whereby different parts of a business actually "charge" each other for the goods and services they provide, always ends up sheltering underperforming businesses, as the experience of the integrated oil giants amply demonstrates. And the need to manage a basket of substantially different businesses blurs the focus of top management.⁸

Yet in two situations it still makes sense to remain integrated:

• If the ability to retain customers in one business depends on service levels in another. In Sweden at present, the level of service offered by the distribution business has a significant impact on the utilities' ability to hang on to domestic retail customers.
• If the ability to retain customers depends on a brand image that embodies more than one part of the value chain. In the United Kingdom, for instance, industrial buyers may be more likely to buy from a company they perceive to be involved in generation.

The new value chain: Long and short term

Eventually, all EU markets will be competitive, so utilities must understand where and how they can eventually prosper in the different sections of the value chain (Exhibit 3). What do the different businesses hold for utilities?

• Generation is almost a "no-win" trap for established players in the long term, but its short-term profitability could be significant.
• Transmission and distribution provide attractive opportunities in some countries.
• The domestic retailing market seems to be attractive structurally, but aggressive competition for market share could destroy margins. Ease of entry into and exit from the industrial retailing market may rapidly increase competition and depress margins.
• Trading offers a new profit opportunity for innovative players.

But as we have suggested, though competition must come eventually, "eventually" means different things in different places. Scandinavia and the United Kingdom are already competitive; the Netherlands and Spain are close behind; Italy, Germany, and Eastern Europe are upward of five years away; and France is even further behind. As a result, the utilities, where they can, should work to slow down the pace of liberalization.

Generation

Established vertically integrated European utilities typically achieve electricity prices well above the level that would cover a new entrant's costs and provide a decent return on capital. Such conditions make the markets of established utilities attractive to new players, which can shelter under that price umbrella.

This is a dangerous state of affairs for incumbents, since high prices and generation volume are often their principal value drivers. As new players enter, established ones can either maintain prices and lose market share or keep market share by letting prices slide. Most players choose to shrink because the net present cost of a price decline in the short term dwarfs the net present value of retaining a larger volume in the long term.

The end game, however, will almost certainly be low cyclical profitability in the fundamental commodity, which is subject, like the products of most basic materials industries, to cycles of overbuilding.⁹ Unless established generators start adapting themselves well before effective competition appears, many may simply not be able to handle the challenge. It is hard to believe that they will succeed in changing their culture or acquiring the necessary skills in cost reduction, risk management, trading, and the like.¹⁰

So the established utilities should do what they can to make the transition to the end game last as long as possible—in which case keeping prices up will yield handsome profits. In the United Kingdom, generation has produced nearly ten years of profits despite substantial new competition from the outset.

One key factor for profitability is the number of players in the market: a useful rule of thumb is that four is attractively few, six unpleasantly many.¹¹ Regulators ought to be persuaded that handing out licenses for new plants too freely and quickly will probably overwhelm the market with gas plants using new technology and that this, in turn, might present a series of problems. Where appropriate, established utilities should make sure that relevant decision makers fully understand all of the broader effects of liberalization, including reduced fuel diversity, dependence on imports,¹² vulnerability to gas infrastructure bottlenecks, loss of network operational flexibility, loss of employment in traditional industries, and social dislocation.

Established utilities should also urge upon regulators the examples of California and Spain. The government of the State of California has recognized that it encouraged utilities to invest in assets that competition will promptly strand. Accordingly, state regulators have agreed that full competition must not prevent the utilities from recovering their costs, and implemented an electricity-unit tax whose proceeds will go to the owners of stranded assets. The government of Spain has allowed utilities to securitize their stranded costs; financial institutions have taken 4.5 percent of the tariff to fund the agreed liabilities.

Having made whatever arguments are appropriate for moving toward competition with caution and even compensation, the established generators must use this period to restructure their portfolios to capitalize on short-term asset price values. Generation assets in particular may trade at high prices if players foresee a continued oligopoly. Generators should also consider swapping assets to put themselves in a stronger position in the markets of the future—for example, by retaining only the most flexible (and therefore competitive) plant or by swapping into markets that are liberalizing more slowly than others.

The approach we recommend stands in direct contrast to the distressingly common pursuit of "copycat" expansionary strategies, whereby players use their money to buy up entire integrated companies in neighboring countries and merely duplicate the ultimately weak positions they hold in their home markets.

Transmission and distribution

For a utility that has already achieved efficient scale (that is, 400,000–500,000 customers¹³), the major short-term value driver is the regulatory game itself. In many markets, regulators are still relatively ill-informed, so distributors often find it more rewarding to beat the formula that determines prices than to cut costs straightforwardly.¹⁴ Many distribution companies whose prices are regulated by an RPI-X formula, for example, make negative-NPV investments because of the incentive to boost the capital base on which the revenue of such companies is calculated.

Eventually, regulators become more sophisticated, and many parts of the distribution business — for instance, metering and construction — become genuinely competitive. Yet after the short-term regulatory game has been played out, "win-win" possibilities with the regulator will remain because regulatory incentives rewarding companies that pursue productivity gains are likely to emerge, even in the shrinking natural monopoly of the core wire business, where competition simply is not feasible.

Besides matching wits with the regulator, there are opportunities to achieve best-practice productivity and efficient scale where they do not currently exist. In Scandinavia and in Germany, outside the "big eight" distributors, utilities have a chance to consolidate fragmented subscale local businesses on a regional basis. France, Italy, Iberia, and the United Kingdom present fewer opportunities for consolidation, but greater productivity is still available through changes in corporate ownership, which can promote better management and the application of technology. UK distribution companies demonstrate a wide range of cash costs, and even the better performers among them are 20–25 percent below best-practice levels.

Finally, in Eastern Europe, privatization and the adoption of best European practices in capital management and work methods would create significant value.

Industrial retailing

The industrial market, with its low barriers to entry and large volumes, attracts new players and joins them with sophisticated buyers. As a result, the "plain-vanilla" product—electrons bundled with a fixed-price contract—is not likely to pay returns above the cost of capital. Experience in the United Kingdom and Scandinavia suggests that industrial customers are enthusiastic about shopping around for electricity and gas, forming purchasing and lobbying groups and exchanging information about best practices. In contrast to most established utilities, these industrial customers are astute negotiators. In the United Kingdom and Germany, buyers have exploited the entry of new players to depress prices—even if these buyers end up staying with their established suppliers. In the United Kingdom, industrial prices fell 8–9 percent in 1997. Since the coming of privatization in 1990, prices have declined by 22–30 percent, depending on the initial tariff.

There is some evidence from the United Kingdom and Scandinavia that industrial buyers prefer known brands and known electricity generators and suppliers to traders or unknown new marketers. Some UK retailers have managed to capture a premium of up to 4 percent for their brands. But this will not prevent margins from being competed away as new entrants pile in and new business systems are quickly copied. If the regulatory authorities permit or encourage easy entry into and exit from the industrial retailing market, it will become a low-margin business. Deprived of the captive buyers that vertical integration gives generators, they will offer low prices in the industrial market to secure generation output and a firm (though low) price hedge.

Players seem to have few ways of preventing or reversing this trend. Bundling gas or other services is not likely to attract sustainable premiums, because the buyers are astute about unbundling and want to pay no more than the true cost of discretionary services.

Domestic retailing

The domestic market could be structurally attractive for established utilities. But this will be true only if retailers can "decommoditize" the market by developing new products, services, and skills that build barriers around existing customer relationships, as successful telecom players do. Otherwise, cherry picking and competition for share may substantially depress margins.

A critical factor in domestic retailing is the extent to which domestic customers are "sticky"—that is, require a substantial discount to switch suppliers. In all likelihood, only this stickiness makes it possible for retailers to charge a price that allows them to recoup their risk-adjusted cost of capital for this basic commodity. Fortunately for incumbents, evidence from competition in electricity, gas, and telecoms suggests that domestic customers are very sticky indeed. In the UK domestic gas market, even with discounts of 15–25 percent, just 20–25 percent of all customers have switched suppliers after a year of competition.

Under these circumstances, established players should be able to earn attractive margins; for recent entrants, the cost of acquiring new customers is simply too high. Things will go wrong only if the established players seek to increase their market share through overly aggressive conduct, thus competing away their margins and sensitizing domestic customers to competition and discounting.¹⁵

Established utilities therefore have the most inimitable asset and the one that confers the greatest structural advantage upon its possessor: a relationship with sticky customers. To protect this advantage as far as possible, incumbents should take the following steps:

• Focus their regulatory strategy on keeping the number of major competitors to four or fewer.
• Minimize cherry-picking opportunities for new entrants by re-balancing tariffs and passing on cost savings before the coming of competition. Utilities typically subsidize industrial customers at the expense of domestic ones, which is exactly what creates enormous cherry-picking opportunities for attackers. Instead, utilities should exploit the fact that they currently control both distribution and retailing to pass on to domestic customers the benefits of true (lower) costs and even some of the savings in distribution costs yielded by moving to best practices in managing the wires business. UK regional electricity companies cut prices to domestic customers by 5 percent in 1997, solely as a result of cost savings in distribution. Partly because of this positioning, only British Gas Centrica has so far declared that it will enter the electricity retailing market.
• Enhance the "stickiness" of current customers by bundling products and services with the basic commodity. Besides adding value, this will reduce the cost of serving customers (through economies of scope) and increase the complexity and opacity of pricing, thus reducing the apparent attractiveness of switching. In the United Kingdom, Scottish Power, United Utilities, British Gas Centrica, and Hyder supply more than one utility to customers—for instance, power and gas or water or telecom services. Swedish oil companies are starting to bundle heating oil, electricity, and gasoline to domestic consumers. Another possibility is affinity marketing—for example, the bundling of financial services, energy, and so forth through such consumer groups as motoring organizations and senior citizen associations.

Innovative service can be a substitute for price discounting

In addition, established players should recognize that stickiness, while it creates some barriers to entry, will not permanently compensate for weaknesses in skills, systems, and scale. To avoid the eventual need to cut prices across the board to compete with new entrants that offer a higher level of service, companies must build the ability to present distinctive value propositions to different segments. As in other commodity-retailing industries, innovative service can deliver benefits comparable to price discounting, but at much lower cost to the retailer. In gasoline retailing, for instance, innovative players—such as Shell with promotions, Jet (the gasoline retailer owned by Conoco) with unmanned stations, and supermarkets with loyalty schemes—forced less skilled rivals to respond with expensive price discounts.

Trading

Vertically integrated utilities generate power to meet demand through a massive exercise in internal optimization. When markets liberalize, so that generators and retailers compete, some force must balance supply and demand. Trading will emerge both to balance them and to manage risk.

Who will capture the trading business opportunity? At first, players with sufficient scale to gain information advantages and to implement adequate risk-matching systems will make money with basic options, as well as forwards and physical swaps. In the US and the UK gas-trading markets, margins of 5–10 cents/therm were common in the first three or so years of deregulation.

As the industry matures (two or three years from now in the US natural-gas market) plain-vanilla products will earn no more than compensatory returns. Only innovators that move up the evolutionary ladder of derivatives and cross-market products will make money—linking, for example, electricity prices with petroleum, gas, coal, inflation, paper pulp, and so forth.

Traders will do well in fragmented markets because information about volumes and prices will be dispersed among many players of varying sophistication, thereby giving traders an opportunity to capitalize on superior price information and risk management. This scenario of fully fledged trading markets, a real one in Scandinavia, is being pushed quite strongly by regulators in the United Kingdom.

What can established utilities do now?

Established utilities will suffer if they plunge into the waters of competition before they have matched the productivity or skills of new entrants. All incumbents should be building on their current structural advantages to improve productivity, build skills, and transform their "satisficing" culture.

They should do two things to exploit their structural advantages—customer relationships, fully invested assets, market share, and relationships with government bodies and regulators:

• Protect short-term value by persuading regulators to raise barriers to entry. In generation and industrial retailing, the likely end game is a low-margin commodity market. Established players will therefore maximize value with a strategy that concentrates on maintaining it in the short term. If the strategy succeeds, the "short term" may be measured in years, and the shareholder value created will be enormous.
• Use market share and relationships to provide a time window for developing skills, products, and services in domestic retailing and trading. Customer relationships and market share should be used to deter new entrants in the short to medium term. Established players should exploit this opportunity to build long-term value. In the domestic retail business, for example, they ought to cultivate relationships with their current customers, improve their level of service, and refine their customer segmentation policies to forestall cherry picking by potential new entrants. At the same time, the skills needed to capture value in the long term, such as risk management and innovation in products and systems, should be developed or acquired.

Established utilities should engage in "no regrets" actions to boost value across the range of businesses. All parts of the value chain should target best-practice levels. In our experience, most established utilities could improve their performance in operating costs and fuel purchasing by 10–25 percent, their capital efficiency by 10–40 percent, and (focusing on the most profitable segments) their customer profitability by 5–15 percent. Even in such low-margin end-game businesses as generation, the attractiveness of the ultimate arena will be much greater if performance improves.

Growth options must be identified. Some businesses are heading for a low-margin end game, so opportunities for expansion must be sought elsewhere. Possibilities that could pay off within five to ten years are many. There may be new technologies for telecoms using the electricity wires network—digital communication and Internet hook-ups, for instance. Alternatively, new telecom networks may be created simply by hanging fiber-optic cable on existing power pylons. Other possible strategies include expansion into adjacent European markets where there is scope for leveraging cost advantages, entry into key growth regions in Asia and Latin America, and entry into adjacent segments of the value chain or selected niches and slivers, such as metering and energy services to industry (Exhibit 4).

Another possibility is "demerging." Vertical disintegration may serve the interests of shareholder value as markets liberalize and the justifications for vertical integration fall away. And because vertical integration is characteristically perceived as anti-competitive, a company can gain much credit with governments, regulatory authorities, and the wider public by suggesting a demerger.

Starting from the top...

Implementing this sort of strategy will pose enormous challenges for top management. While major improvements in performance are being introduced, the company must maintain its managerial and operational effectiveness. It must also prepare the way for a radically different business in five to ten years and at the same time maximize the short-term value of existing businesses by limiting the rate at which regulators move to liberalize markets.

It is hard to balance efforts to prepare for change, on the one hand, and to limit its pace, on the other. Can established utilities perform such a feat? Large, complacent monoliths, historically protected from competition and the sharp knives of the investor community, are often culturally inimical to the level of flexibility and innovation that is required.

Established utilities face a difficult process of implementing major changes. Nonetheless, in many parts of their businesses they have substantial structural advantages. If they move now to prepare for competition, they can both protect existing value in the short term and create value in the long term. But it will take visionary and determined top management to bring this about.